Was $600 Billion QE2 A Waste of Money?

The Federal Reserve is wrapping up its $600 billion QE2 treasury bond-buying program this month. Did it work or was it a waste of money? Some media analysis of QE2's effectiveness is shoddy. Based on the Fed's goals for QE2, the program was of mixed effectiveness. And from a societal cost-benefit perspective, QE2 was a waste of money.

What is so shoddy about the media's analysis? Let's take the Wall Street Journal's Jon Hilsenrath. He concluded that QE2 stopped deflation but did not boost the economy. Hilsenrath is right about one thing -- there is no evidence of deflation and the economy slowed down.

Where he goes off is his attempt to suggest that QE2 caused those outcomes. Let's examine his logic on some of the key variables:

Deflation. Deflation is a drop in the general level of prices. There was no deflation before QE2 nor is there any now. In Nov. 2010, the general inflation rate was 1.1% and as of May 2011, it was 3.6%. Hilsenrath claims that QE2 is responsible for the increase in inflation. But inflation consists of two parts -- commodity prices and wages. Commodity prices rose because speculators who control 81% of trading on the commodities exchanges were able to place highly leveraged bets on rising prices and a declining dollar. When CME Group (CME) demanded higher margin requirements, the prices fell. Meanwhile, labor rates actually rose 0.7% in the first quarter of 2011 after declining 2.8% in the fourth quarter of 2010. If those labor rates keep rising, the Fed may be forced to raise rates to stop inflationary expectations - but it's not obvious that QE2 had anything to do with that rise. In short, Hilsenrath is wrong to argue that QE2 boosted inflation.

Stock market. The stock market -- as measured by the S&P 500, is up from 1,047 the day before the Fed announced QE2 in Aug. 2010 -- it's up 24% since. Hilsenrath argues that QE2 "appears to have helped push stock prices higher." In fact, nobody knows why stock prices move up and down so I suppose he could just have easily have argued that stock prices went up because of President Obama's successful attack on Osama bin Laden.

Growth slowdown. Since QE2 was launched last November, GDP growth has slowed down from 3.6% in the fourth quarter to what Hilsenrath estimates will be 2% for the first half of 2011. But what did QE2 have to do with this? In theory it was supposed to get more cash into the hands of banks that would use it to lend to businesses and consumers. Instead, banks bought government bonds. And growth slowed down because every $10 a barrel rise in oil cuts economic growth by half a percentage point. From February to May, oil's price/barrel spiked $30 from $85 to $115 so a 1.5 percentage point decline in GDP growth would have been expected. I don't think QE2 had anything to do with that price spike.

So how should we think about QE2? One way is to look at what the Fed intended. According to its statement last November, the purpose was to boost job creation and inflation -- "In light of persistently weak job creation and declining inflation, the Federal Open Market Committee’s recent actions reflect those mandates."

By that measure, QE2 has failed. Its impact on inflation is unclear -- although overall inflation has risen -- and job creation remains weak. Nevertheless, the unemployment and job creation statistics were better in May 2011 -- when the unemployment rate was 9.1% and U.S. employers added 54,000 jobs than they were last November when the unemployment rate was 9.8% and U.S. employers added 39,000 jobs.

Rising prices may well have crimped consumer spending which means lower growth and lower need for workers. In short, whether QE2 had anything to do with inflation, that inflation has applied the brakes to economic growth.

Another way to think about QE2 is to consider its societal costs and benefits. From that perspective, the biggest cost is the missed opportunity if that $600 billion had been used more effectively. To me, it appears that the best case that the Fed can muster for QE2 is that options markets suggest that investors cut their expectations of the odds of deflation from 40% before QE2 to 10% now.

Other than that, it is hard to see any benefits from the program. But what if that $600 billion had been given to consumers -- perhaps in the form of a tax refund -- who account for 70% of economic growth? If consumers had spent that $600 billion, it might have boosted GDP growth substantially.

I know that's outside the Fed's purview but based on the evidence so far, I don't know how the Fed could justify a QE3.